The case for raising taxes on private equity

I used to write a lot about the tax treatment of carried interest, or the “cut” of investment profits that private equity managers keep for themselves. I would argue that carried interest is a contingency fee for services rendered (investing other people’s money), and should therefore be taxed as ordinary income (35%) rather than as capital gains (15%). You know, taxed like the rest of us.

But then I stopped. Not because my opinion changed, but because I lost faith that Congress would do the right thing.

Rep. Sanders Levin (D-MI) introduced the original legislation in 2007, but it couldn’t overcome a threatened veto from President Bush. Subsequent efforts met a similar fate, despite supportive Democrats increasing their congressional majority and capturing the White House in 2008. Fed up, I promised to never write again about carried interest taxation, unless it seemed likely that politicians were finally about to close the loophole.

So it is with great trepidation that I write this post. There has been no relevant legislation introduced, but President Obama has said that changing the tax treatment of carried interest would have to be part of any grand bargain on the debt ceiling increase. And some Republicans recently indicated that they would accept certain tax code alterations in exchange for deep spending cuts, although a chance remains that the party will simply replace its symbol with one of an elephant biting off its own trunk.

Call me a cock-eyed optimist who believes that our elected leaders will ultimately choose their nation’s well-being over their partisan dogmas. And, in doing so, make an overdue step toward tax fairness and simplicity.

Why change is neededFor the past ninety years, capital gains have been taxed at a lower rate than has ordinary income. The specifics have changed over time, but the core policy objective has remained constant: Encourage private sector investment, because it helps foster job growth, new company formation and other economic boons. It’s an incentive for people to take financial risks that help keep America prosperous.

In many cases, people invest their own money directly and pay capital gains rates on any subsequent profits. In others, they pay an investment adviser or mutual fund manager to invest on their behalf, in exchange for a fee. The actual investor still receives capital gains treatment in these arrangements, while their adviser pays ordinary income on their fees.

Alternative investment funds, however, operate differently. They structure themselves as partnerships, so that both the investor (limited partner) and fund manager (general partner) are effectively treated as a single entity for tax purposes. Investment profits flow into the partnership as capital gains, and then are divvied up between the two sides at a pre-negotiated rate — typically with fund managers receiving 20%.

The fundamental problem with this arrangement, of course, is that fund managers don’t actually invest. Don’t actually put anything at risk. If an investment goes bad, the fund manager loses only his reputation. Need proof? Ask a fund manager if he’s ever claimed a capital loss on one of his fund’s investments? Now ask the same question of his investors, and tell me that they’re really all in it together as a partnership.

Debunking the argumentsNone of this is to say that most alternative fund managers don’t work hard or provide a valuable service. They source investments, negotiate terms, sit on portfolio company boards and more. And, in exchange, they are rewarded with their 20% carried interest (no matter the tax rate) and an annual management fee — usually 2% of committed capital — that covers overhead expenses like salary (on which fund managers pay ordinary income).

Some defenders of the current system harp on the aforementioned work, insisting that fund managers deserve capital gains treatment because the capital gain is mainly derived from their efforts. They are the ones creating value. It’s a red herring.

Current tax law makes no distinction between general partners who do a lot and general partners who do a little. For example, how much value creation is being done by VC and PE firms that have invested in Facebook over the past year? Virtually none, but they currently are entitled to the same capital gains treatment as the company’s earliest investors. Moreover, what about funds in which most of the carry is generated by junior partners, but in which senior partners are contractually entitled to a larger share? Why should those senior managers get capital gains treatment from profits created by someone else’s work and someone else’s money?

The common reply from alternative fund managers is: “Well, what about homeowners? Don’t they take money from someone else (a bank) and then book a capital gain if they sell the asset at a profit?”

Yes, they most certainly do. But here’s something homeowners don’t do: Receive an annual management fee from the bank, in exchange for improving the house’s value. If anything, service payments go in the opposite direction. And, again, homeowners can suffer a loss of equity on their homes. For fund managers, the worst they can do is collect only their management fees.

It is at this point that industry defenders return to the partnership structure: “What business is it of the government’s to determine how an investor wants to split its profits? In fact, our investors would rather we have higher carried interest and lower management fees, because it better aligns our interests.”

The government couldn’t care less how you split your profits. It simply should have an interest in restricting its tax incentives to those it is actually trying to incent (i.e., investors). If fund managers really want to align interests, then they should make substantial investments in their own funds (many do). Profits derived from those investments would continue to be treated as capital gains, under every proposal that has come out since 2007.

Some fund managers argue that they effectively give up high up-front payments in exchange for the carry and, as such, deserve credit from the federal government. Sounds kind of like what I did at my last job, when I negotiated for a percentage of website profits instead of asking for a higher salary. Only difference is that, when my bonus arrived (due to the value I helped create based on my employer’s initial investment), I got taxed at ordinary income rates.

A corollary to the partnership argument is: “But if you change the tax treatment, fewer people will choose manage funds. That will lead to fewer investments, thus defeating the primary policy objective of capital gains.”

If true, this would indeed be a problem. Luckily, it’s a canard. For the past four years, I’ve occasionally asked my email newsletter readers — most of whom are fund managers — to tell me if a change in tax treatment would cause them to seek other work. To date, no one has replied affirmatively. I also asked the question yesterday on Twitter, and heard only crickets and a couple fundmanagers who said that tax rates were irrelevant to their career plans.

Need more proof? The greatest increase in new VC fund creation was in 1999-2000. At the time, capital gains rates were substantially higher than they are today. Even more striking: There wasn’t an increase in new fund creation when President Bush slashed capital gains rates in 2003.

Alternative fund managers are not created or destroyed by short-term tax considerations that can change on a congressional whim. It is a long play, in which successful fund managers can amass financial fortunes regardless of whether taxes are being paid at 15% or 35%. Think the early Zynga investors are fretting about a tax change?

To be sure, I recognize that most alternative fund managers aren’t in Zynga. Or Facebook. Or Groupon. And it certainly is hard to get “in the carry,” particularly because many funds must first pass a hurdle rate (i.e., minimum return on investment). But capital gains treatment was created to encourage risk-taking investment, not ambitious work. If fund managers want to apply some sort of “degree of difficulty” standard to taxes, that’s their prerogative — although I know some teachers, nurses, engineers and manual laborers who might bicker over the judging criteria.

Alternative fund managers are an important part of our capitalist economy. They simply aren’t investors, and should stop being treated as such by the IRS.